Avoiding the Tax Penalty If You Take Early Retirement

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Avoiding the Tax Penalty If You Take Early Retirement Some people would like to take early retirement but are concerned about having access to retirement accounts without tax penalties. Withdrawals from IRAs are subject to a 10% tax penalty (plus the tax) when taken before age 59 ½. The IRS provides several exceptions to the 10% penalty including:

  • Rollover within 60 days
  • Death
  • Permanent disability as defined by the Internal Revenue Code
  • Unreimbursed medical expenses in excess of 7.5% of your adjusted gross income
  • Qualified higher education expenses
  • Purchase, building, or rebuilding of a first home ($10,000 lifetime limit)
  • Payment of medical insurance during a period in which you received unemployment compensation for at least 12 weeks
  • Inheriting an IRA
  • An IRS levy
  • Distributions taken as a series of substantially equal periodic payments (72 (t) payments)

Most of these exceptions won’t provide you with the regular income you need to take early retirement except 72(t) payments. This exception is generally the surest way to make yourself eligible for penalty-free retirement account withdrawals before age 59½. To implement these payments in your early retirement strategy, simply follow these three basic rules:

  • You must take a series of withdrawals (at least annually) with the amounts based on one of three methods: minimum distribution, fixed amortization, or fixed annuitization.
  • With a company plan or 401(k), you must be separated from service. That means you must have quit, retired, been laid off or fired, or otherwise left your job. With a traditional or Roth, SEP, or SIMPLE IRA, you can use the 72(t) strategy at any time.
  • Once you start taking 72(t) withdrawals, you must stick with the program for at least five years or until you reach age 59½, whichever comes later. You can’t modify the account or payments in any way. To do so will subject all payments taken under the plan to the 10% premature withdrawal penalty.

The method you choose will make a big difference in the amount of withdrawal. Withdrawals are calculated on an annual basis, but income can also be taken monthly or quarterly. The method you choose cannot be changed so it’s important to work closely with a financial adviser to establish a distribution strategy that meets your individual needs. As with all Traditional IRA withdrawals, payments taken under 72(t) are taxable as income in the year they are received.

Minimum distribution method: This method divides the IRA account balance by a divisor from an IRS single or joint life expectancy table. This method results in payment amounts that fluctuate each year, allowing the IRA owner to withdraw the least amount of income.

Fixed amortization method: The amortization method calculates the annual distribution amount by amortizing your account balance over single or joint life expectancy. This method, which provides fixed annual payments, may be appropriate for individuals who would like to withdraw as much as possible from their IRA.

Fixed annuitization method: The annuity method uses an annuity factor, provided by the IRS, to calculate substantially equal periodic payments. This method provides individuals with steady fixed annual payments.

Don’t like the calculation method you’ve chosen?
If you find your current distribution method is providing you with more income than you need you cannot claim the 60-day rollover rule and roll the payments back into your IRA. To do so could disqualify the 72(t) strategy and subject all payments to the 10% penalty. Should you be concerned about depleting your IRA, the IRS permits individuals to make a one-time conversion from one of the fixed-dollar calculation method to the Minimum distribution method without a tax penalty. Once you choose the conversion, the new method must be used in all subsequent years, and the five years period or until age 59½, whichever is longer (with credit given for any previous years’ payments) is still in effect.

We often recommend dividing the account and electing different methods of 72(t) withdrawals to add flexibility to the payments. The minimum distribution has the smallest annual distributions but the amount increases each year. Establishing a second 72(t) IRA using one of the fixed income methods can provide steady income generation while allowing the first IRA account to provide annual increases.

Rick’s Insights

  • The IRS provides 10 exceptions to the 10% early withdrawal penalty.
  • IRS rule 72(t) allows penalty free withdrawals from a traditional IRA provided they are taken as a series of substantially equal periodic payments.
  • There are three methods for calculating 72(t) payments which generally cannot be altered once payments have started.

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